A TALE OF TWO TYPES OF BANKING SYSTEMS—AND WHY WEAK AND STRONG BANKING SYSTEMS MATTER TO INVESTORS
THE WEAK BANKING SYSTEMS
Weak banking systems can be found in Western Europe, the U.S., Japan, the Baltic states, Iceland, and much of Eastern Europe. The weakness of these banking systems has caused economic growth to slow dramatically.
There has been much reporting of the events of the past two years in the world press which backs up our view. Some banks in these regions were so devoid of common sense that the creators of toxic assets held the junk they had created in their own portfolios. Lehman Brothers comes to mind among many other European, Japanese, and U.S. institutions.
The banking crisis was fueled by a failure of common sense, combined with inadequate regulation. The catastrophe was promoted by politically driven wishful thinking and fraud by participants at all levels. Further, the problems which caused the crisis have not been remedied. The same regulators continue to coddle the banks and allow them to go on creating destructive and toxic derivative instruments. Taxpayers have been penalized while the foolhardy, destructive and ignorant have been rewarded with bailouts.
The overall consequence of this banking crisis is a long term slowdown that may take years to remedy. Many nations will continue to experience consequences for their weak banking systems, and the capital needed for companies to grow will not be readily available in these countries for some time.
The strong countries include Canada, Hong Kong, Singapore, Brazil, India and China, and many other Asian nations. Not every country acted foolishly. Some countries were either smart, lucky, or both. When evaluating the situation we notice that there are two kinds of countries with strong banking systems.
The Strong-Group 1
These are the nations that were wise and willing to resist temptation of leveraged derivatives. They included Canada, Australia, Singapore, Korea and Hong Kong. These countries were conservative in their banking practices and did not spend their capital on derivative backed bonds based upon the real estate market and in associated bond instruments. They did not make many sub prime loans and they did not package these loans into syndicated piles of toxicity, which were sold to the naïve and unsuspecting. The regulators in these nations acted to disallow anyone who wanted to leverage their balance sheet to dangerous levels from doing so.
The Strong-Group 2
The second group of strong banking system nations, including China, India and Brazil, also refrained from dabbling in highly leveraged derivatives. Instead, they prioritized making loans to their own citizens to foster growth in their own nations and did not have the need or political inclination to make loans to real estate borrowers who would not be able to repay.
Quite intelligently, banks in these countries have been busy lending to build the infrastructure in their nations, to finance the growth of business and consumer spending and to do the rational, conservative banking that will foster growth and raise the standard for living for their people. In these cases, there was no need for regulation against unwise behavior except the normal capital requirements traditionally required of banks.
THE RESULT – WE PREDICT THAT THERE WILL BE WEAK ECONOMIC GROWTH IN MAJOR NATIONS WITH DAMAGED BANKING SYSTEMS
It is not difficult to see that a strong banking system is a necessary component of a healthy economy with strong economic growth. Capital is required for companies to be formed and to grow. Without capital being distributed in the form of loans through the banking system, there can be no steady and durable economic growth. Capital distribution can also take place through the banking system in the form of stock sales by companies to the banks’ customers. The above can happen in countries with struggling banking systems, but only at a reduced level.
Investors are used to thinking of developed countries as more stable than their developing counterparts. In the last two years however, everything has been turned on its head. Today we see that some developing countries have more stability and something many developed countries lack – strong banking systems.
An example of a developing country with a solid banking system is China. Chinese companies are able to raise record amounts of capital through foreign investment, stock sales, and retention of payments surpluses.
At the same time, most developed countries are relying on debt financing to fund their financial bailouts and budget deficits. The U.S., for example, is floating so many bonds to finance its $1.8 trillion dollar budget deficit that it’s crowding companies, cities and states out of the debt markets. When the Federal government is borrowing that much money, it is very hard for a small city or a state to sell bonds. Many buyers are getting all their bond needs satisfied with Federal government bonds. A combination of low to no bond sales and low tax collections for states and cities, means low capital formation, and without capital formation, economic growth is very difficult.
When will strong regulation emerge? So far it’s not looking good. If the Obama administration caves into the banks and traders and does not regulate derivatives, a much bigger derivatives crisis will occur in the near future.
In light of the above it is not difficult to see the logic of many economists who predict slow growth in those nations with weak banking systems.
WE PREDICT STRONG GROWTH IN THOSE NATIONS WITH GOOD BANKING SYSTEMS
One of the major lessons in business school is that enterprises are funded by a combination of equity [stock sales to the public or private sales to venture capitalists], and debt [borrowing from banks or from long term debt investors].
A successful company does not want too much debt because it makes them more susceptible to failure if times get tough. On the other hand, a company does not want too much equity financing because this dilutes earnings growth and stock price appreciation, if they sell too much stock it will dilute the value of the existing shares. A balance is necessary. In the case of the U.S., Japan, and Europe, the balance is missing. Too much debt is being used to bail out the banking systems, and to stimulate their economies.
This is not the case in the growing countries and growing companies. In both of these cases a balance exists between invested money [equity] and borrowed money [debt].
OUR INTEREST IN GOLD AND OIL IS A RESULT OF THE OVERUSE OF DEBT FINANCING IN DEVELOPED NATIONS—ESPECIALLY THE U.S.
If a country accrues too much debt, they are possibly in a position of not being able to repay it. This is because the debt servicing cost becomes too high and cannot be covered by the taxing ability of the nation. Only taxes received in excess of spending can be use to pay debt. Historically, when faced with similar situations, many countries have lowered the value of their currency and repaid the debt in depreciated currency units. When currencies depreciate in value (as the U.S. dollar has been doing over the last few years) people naturally look for dollar substitutes such as gold, oil, other commodities and real estate. Many of these can be good alternatives that will not depreciate. Maintaining buying power is essential for people to enjoy financial security and many seek to do so by owning the aforementioned instruments.
The monsoon for India in 2009 is below plan in the north and will affect the nation’s northern crops. Much of India remains rural and very dependent upon the farm sector to produce adequate income for the nation’s massive number of farmers. This news concerns us but thus far the Indian market has not declined. We will wait to see if it has the expected effect or if Indians are so bullish on the positive election results, plans to increase infrastructure spending and educational opportunities, and the push to root out corruption that they will move the market up in spite of the GDP slowdown.
The inadequate monsoon could slow Indian economic growth to about 5 percent in the coming year.
As we have long argued, Asia has led the world economic rebound. Below is an article which summarizes much of our thinking on Asia from this past weekend’s The Economist.
An astonishing rebound
Aug 13th 2009
Asia’s emerging economies are leading the way out of recession; now they must make their recovery last.
IT NEVER pays to underestimate the bounciness of Asia’s emerging economies. After the region’s financial crisis of 1997-98, and again after the dotcom bust in 2001, outsiders predicted a lengthy period on the floor—only for the tigers to spring back rapidly. Earlier this year it was argued that such export-dependent economies could not revive until customers in the rich world did. The West still looks weak, with many economies contracting in the second quarter, and even if America begins to grow in the second half of this year, consumer spending looks sickly. Yet Asian economies, increasingly decoupled from Western shopping habits, are growing fast.
The four emerging Asian economies which have reported GDP figures for the second quarter (China, Indonesia, South Korea and Singapore) grew by an average annualised rate of more than 10%. Even richer and more sluggish Japan, which cannot match that figure, seems to be recovering faster than its Western peers. But emerging Asia should grow by more than 5% this year—at a time when the old G7 could contract by 3.5%. Western politicians should brace themselves for more talk of economic power drifting inexorably to the East. How has Asia made such an astonishing rebound?
Out of smoke and mirrors, say some Western sceptics. They claim China’s bounceback is yet another fake. The country’s numbers are certainly dodgy: the components of GDP do not add up, and the data are always published suspiciously early. China’s economy probably slowed more sharply in late 2008 than the official numbers suggest. But other indicators, which are less likely to be massaged, confirm that China’s economy is roaring back. Industrial production rose 11% in the year to July; electricity output, which fell sharply last year, is growing again; and car sales are 70% higher than a year ago.
And surely the whole of Asia cannot be engaged in a statistical fraud. South Korea’s GDP grew by an annualised 10% in the second quarter. Taiwan’s probably increased by even more: its industrial output jumped by an astonishing annualised rate of 89%. India was hit less hard by the global recession than many of its neighbours because it exports less, but its industrial production has also perked up, rising by a seasonally adjusted rate of 14% in the second quarter. Output in most of the smaller Asian economies is still lower than a year ago, because they suffered steep downturns late last year. But at economic turning points, one should track quarterly changes.
Thrift in the boom, stimulus in the slump
Asia’s rebound has several causes. First, manufacturing accounts for a big part of several local economies, and industries such as cars and electronics are highly cyclical: output drops sharply in a downturn and then spurts in the upturn. Second, the region’s decline in exports in late 2008 was exacerbated by the freezing up of global trade finance, which is now flowing again. Third, and most important, domestic spending has bounced back because the fiscal stimulus in the region was bigger and worked faster than in the West. India aside, the Asians entered this downturn with far healthier government finances than rich countries, allowing them to spend more money. Low private-sector debt made households and firms more likely to spend government handouts; Asian banks were also in better shape than their Western counterparts and able to lend more. Asia’s prudence during the past decade did not allow it to escape the global recession, but it made the region’s fiscal and monetary weapons more effective.
Western populists will no doubt once again try to blame their own sluggish performance on “unfair” Asia. Ignore them. Emerging Asia’s average growth rate of almost 8% over the past two decades—three times the rate in the rich world—has brought huge benefits to the rest of the world. Its rebound now is all the more useful when growth in the West is likely to be slow. Asia cannot replace the American consumer: emerging Asia’s total consumption amounts to only two-fifths of America’s. But it is the growth in spending that really matters. In dollar terms, the increase in emerging Asia’s consumer-spending this year will more than offset the drop in spending in America and the euro area. This shift in spending from the West to the East will help rebalance the world economy.
Beijing, Bangkok and Bangalore: beware boastfulness
It is easy to boost an economy with lots of government spending. But Asian policymakers now face two difficult problems. Their immediate dilemma is how to sustain recovery without inflating credit and asset-price bubbles. Local equity and property markets are starting to froth. But policymakers’ reluctance to let their currencies rise faster against the dollar means that their monetary policy is, in effect, being set by America’s Federal Reserve, and is therefore too lax for these perkier economies. The longer-term challenge is that once the impact of governments’ fiscal stimulus fades, growth will slow unless economic reforms are put in place to bolster private spending—something Japan, alas, never did.
Part of the solution to both problems—preventing bubbles and strengthening domestic spending—is to allow exchange rates to rise. If Asian central banks stopped piling up reserves to hold down their currencies, this would help stem domestic liquidity. Stronger currencies would also shift growth from exports to domestic demand and increase households’ real spending power—and help ward off protectionists in the West.
Hubris is the big worry. With the gap in growth rates between emerging Asia and the developed world heading towards a record nine percentage points this year, Chinese leaders have taken to warning America about its lax monetary policy (while Washington has stopped lecturing China about the undervalued yuan). But it would be a big mistake if Asia’s recovery led its politicians to conclude that there was no need to change their exchange-rate policies or adopt structural reforms to boost consumption. The tigers’ faster-than-expected rebound from their 1997-98 financial crisis encouraged complacency and delayed necessary reforms, which left them more vulnerable to the global downturns in 2001 and now. Make sure this new rise is not followed by another fall.
We continue to favor India and China, Singapore, Hong Kong, oil and gold. The first four are favored because of their current and expected growth profile, and the last two are due to their uniqueness as hedges against the continued depreciation of the U.S. dollar. We would buy all of them on any short term price weakness that they might experience. Fortune favors the bold.
Thanks for listening, and we look forward to hearing your thoughts and comments.
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